Defying gravity, WTI and Brent soared to new heights this week, pushed along by an unlikely ally: U.S. Treasury Secretary Steven Mnuchin.
Mnuchin surprised reporters when he seemed to express support for a weaker U.S. dollar, which flies in the face of longstanding U.S. government policy supporting a strong greenback. The dollar dropped sharply on the news, raising fears of a campaign by the U.S. to push down its currency to gain an edge in exports.
There has long been a solid link between the direction of the U.S. dollar and oil prices. Because oil is denominated in dollars, a weaker dollar makes oil more attractive to all other currencies. That helps stoke demand for crude, so when the dollar drops, oil tends to rise. As such, the decline of the dollar helped push WTI and Brent to new multi-year highs this week.
Mnuchin tried to slightly walk back his comments on Thursday, clarifying that there was no policy change. “There are benefits of where the dollar is and there are costs of where the dollar is,” Mnuchin said at the World Economic Forum in Davos. “It’s not a shift in my position on the dollar at all. It is perhaps slightly different from previous Treasury secretaries.”
The timing was also notable. The comments came just days after the Trump administration slapped tariffs on solar panels, which stoked concern about tit-for-tat protectionism. And when asked, U.S. Secretary of Commerce didn’t exactly shoot down questions about a brewing trade war. “Trade wars are fought every single day,” Secretary of Commerce Wilbur Ross said in Davos. “So a trade war has been in place for quite a little while, the difference is the U.S. troops are now coming to the rampart.” To be sure, this week’s drop only pushed along a trend that was already underway. The dollar has been weakening for more than a year. But the losses for the greenback really began to accelerate since December. The U.S. Dollar Index (DXY), which tracks the greenback against a basket of major currencies, dropped to 88.45 on Thursday, the lowest point since late 2014.
The decline of the dollar since early December also coincided with a rapid run up in crude oil prices. That, along with a rush of speculative bets, has helped push oil to new highs. “The continuous fall in U.S. oil inventories and the prolonged weakness in the U.S. dollar have done the trick,” Tamas Varga of PVM told Reuters, referring to the latest jump in WTI and Brent.
“The depreciation of the U.S. dollar is also allowing oil prices to make further gains,” said Carsten Fritsch, analyst at Commerzbank. “Almost every commodity class is being driven up by this extended dollar fall.”
However, the dollar’s role in fueling the bull run for oil does not mean that current trends will continue. With the dollar at its weakest since 2014, the U.S. government could make more hawkish statements to shore up confidence in its strong-dollar policy. Any rebound in the strength of the dollar could upset the oil price rally.
Moreover, the Fed is likely to continue to tighten its monetary policy. For now, the futures market is pricing in about two small rate hikes in 2018, according to Bloomberg, but there could be more. “Several economic and policy factors are converging that could pave the way for four 25-basis-point hikes in 2018,” Eric Winograd, an analyst at AllianceBernstein LP, wrote in a recent note. Higher interest rates would strengthen the dollar and push oil prices down.
The one thing working in the favor of higher prices is that the fundamentals continue to improve. The EIA reported a surprise draw in crude stocks last week after API figures pointed to an increase. The surprise drawdown buoyed oil prices. Crude stocks are now at 411.6 million barrels, the lowest level since early 2015. And at the important oil hub of Cushing, stocks fell below 40 million barrels, putting them down 40 percent from year-ago levels. The dwindling stocks in Cushing helps explain the sudden narrowing of the WTI-Brent discount, which has shrunk to about $4 per barrel, down from more than $7 a few weeks ago.
In other words, until the inventories start growing again — as many analysts predict will happen at some point in the next few weeks and months — the fundamentals are still supportive of prices.
But the weak U.S. dollar is amplifying the rally.